Taylor Made

No surprises in Friday’s GDP numbers as all were in line with or very close to street consensus estimates. The final read of Q4 2010 GDP indicates that the economy grew at a pace of 3.1%. Although today’s data were encouraging, there are concerns that higher energy prices and the aftermath of global events could erode consumers’ purchasing power, slowing down the pace of the economic recovery.

One economist told Bloomberg News:

“We’re seeing the effects of rising gasoline prices and we’re going to see a negative impact from the earthquake start to show up because of bottlenecks in the global supply chain. Recent data suggests the expansion is a little softer than anticipated.”

The lower than expected University of Michigan Confidence data indicates that consumers are being squeezed by higher food and energy prices. The report is more distressing than it may appear. This is the Final read of the March data. The prior 68.2 was a preliminary report of March data. The February data indicated a index number of 77.5. That is quite a drop between February and March. Today's index of 67.5 was the lowest read of University of Michigan Confidence since a report of 67.4 in November 2009.


There has been renewed interest in forecasting when the Fed will raise the Fed Funds rate. What many people fail to realize is that the Fed can (and probably will begin to change monetary policy without raisin the Fed Finds rate. That will probably come next year. How and why can the Fed begin to change monetary policy without raising rates? I will try to explain.


First, one must understand the Taylor Rule. Simply stated, the Taylor Rules indicates how much a central bank should raise or lower interest rates in response to the divergence of actual inflation rates versus target inflation rates or, in the case of the Fed which does not have an official inflation target, the divergence of the prevailing rate of inflation versus the desired rate of inflation (believed to be in an approximate range of 2.0% to 2.5%).

Using the Taylor rule as a guide, the Fed Funds rate should be in negative territory. However, since the Fed Funds rate cannot be negative (borrowers cannot be paid to borrow money), the effectively lower interest rates, the Fed has engaged in quantitative easing. The result is that short-term interest rates are effectively below zero. This is what Mr. Diclemente means when he says: “asset purchases and commitment language together are the equivalent of lower overnight rates.”



Although the street consensus forecast calls for the Fed to leave the Fed Funds rate unchanged until early to mid 2012, this does not mean that the Fed will not move to a tightening bias. Here are examples of Fed tightening other than raising the Fed Funds rate:

1) Letting QE2 run its course by June and not engage in QE3.


2) Selling its bond holdings. The Fed does not necessarily have to sell its holdings outright. It can engage in reverse repos (A.K.A. reverse repurchase agreements). In a reverse repo, the Fed temporarily sells securities to counterparties with the intention of repurchasing at a later date at a predetermined price. By executing reverse repos, the Fed can temporarily remove money from the system. This effects a Fed tightening without reducing the size of its balance sheet. The Fed can engage in reverse repos (or repos for that matter should it want to add money to the system) enabling it to fine tune policy to economic conditions. The Fed tested the waters and executed a small amount of reverse repos yesterday to test the waters.


3) Jawboning: The Fed could and probably will begin to use language hinting at a less accommodative policy stance. That usually causes market participants to change their trading or investment strategies. The usual result is higher short-term yields. Note: Long-term yields often do not respond in kind (and sometimes remain little changed or even fall) in response to Fed tightening, resulting in a flattening yield curve.




The point I am trying to make is that raising the Fed Funds rate is not the only way, and probably will not be the first way, in which the Fed removes stimulus from the system. Those who are waiting for actual short-term rates to rise may have to wait at least another year before that happens.

Investors should not myopically view higher short-term rates as the Fed’s only method of moving to a tightening bias. They should also be cautioned against making the mistake of believing that higher short-term rates automatically equates to higher long-term rates.

The goal of higher short-term rates is to quell inflation. If inflationary pressures are abated, there would little reason for long-term rates to rise very high. If the Fed is successful, we could see a scenario in which the halt and reversal of quantitative easing accomplish much of the desired inflation abatement and could be followed by only a modest Fed Funds rate increase. Assuming the Fed will be successful in combating inflation, long-term rates during the forthcoming interest rate cycle may also peak at levels below to what we have become accustomed.

The street consensus is in line with this scenario. Here are the Q2 2012 street consensus estimates for interest rates across the yield curve as compiled by Bloomberg News among at least 40 respondents per area of the yield curve.

Fed Funds: 1.00%.

Three-month USD LIBOR: 1.25%.

Two-year Note: 1.95%.

Ten-year Note: 4.25%

Thirty-year Bond 5.25%.

Although the forecast is for higher rates across the curve, the forecast does not call for extraordinarily high interest rates. Considering that QE has effective policy interest rates below zero, a Fed Funds rate of 1.00% may have a similar effect as a 200 basis point (or more) Fed Funds rate increase had during previous interest rate cycles. Where will the Fed Funds peak during the next cycle? It is too early to even forecast, but given the relatively weak economic underpinnings and the slow pace of the recovery, Fed Funds rates may not have to be very high to rein in inflation. It is not inconceivable that the Fed Funds rate peaks at 3.00% or less during the next interest rate cycle.

Last year, a well-respected economist cautioned me that the absolutes during this recovery, including interest rates, could be lower than to what we have become accustomed. In such a scenario, staying overweighted in cash or focusing one’s portfolio in short-term benchmark floaters could be a poor strategy. However, because only relatively-small long-term rate increases are necessary to result in sharp price declines in long-duration securities, one may not wish to overweight the long end of the curve. As is common in life, the answer may lie in the middle.

The belly of the curve, between three five and ten years, may offer the best returns on a risk / volatility-to-reward basis. Our suggestion to investors would be to not try to time the markets, peg a specific area of the curve or focus on a product which may outperform should market conditions play out in a specific fashion and structure a diverse portfolio which should perform well under a variety of market conditions.